Digital Assets for RIAs: How to Prepare for DeFi
Decentralized Finance (DeFi) is unlocking entire new forms of yield opportunities for digital asset holders. RIA’s will need to understand the evolution of digital ownership and DeFi to best advise their clients to prepare for the future. In this article, we will discuss:
- How we got here
- What is DeFi / Web3 and why you should care
- How digital assets produce greater economic activity
- How you can help your clients take advantage of passive yield opportunities
We hope you come away with a solid understanding of the dynamics of Decentralized Finance, how yield is generated in this new space, and how you can be the go-to expert on the ownership economy for your clients.
Digital Assets: Evolving the Digital Economy
In just a few decades, the digital economy has altered how the global economy functions. Commerce isn’t contained to individual countries; ideas, culture, and capital readily flow across borders over the web. To facilitate global commerce, technology and finance intermediaries maintain ownership and settlement data. This data includes our entire digital footprint in the form of demographic information, user created content, bank account information, etc. The ever-increasing value of data has effectively converted data into a capital asset that produces exponential, passive yield over time. With the expansion of cloud computing infrastructure lowering technology requirements, any sized business or individual can now access the digital economy and produce this yield generating asset. Content creators, businesses, and everyday users create millions in wealth everyday just by interacting over the internet. Unfortunately, those that create this wealth only access a small portion of it due to structural problems built around intermediaries. On the tech side, platforms own most of the valuable data created by their users. In finance, specialized access to legacy settlement infrastructure makes transactions only possible through a small group of member financial institutions. Despite SME’s making up 90% of global GDP, these barriers create a system where only scaled enterprise-level corporations and intermediaries can tap the majority of the benefits of the digital economy.
The creation of digital assets changes this dynamic by merging ownership natively on the web. Instead of intermediaries performing the administrative function of maintaining data ownership records on behalf of a network and keeping the yield, the network shares the responsibility and yield. As the digital economy evolves, Web 3.0 emerges to power the ownership economy. To support it, financial infrastructure takes on the form of Decentralized Finance (DeFi), or the financial tools and primitives built for Web 3.0. DeFi acts as a web-native settlement rail performing the financial functionality of intermediaries without worrying about maintaining ownership records. In this structure, individuals and businesses of any side can tap the full benefits of the digital economy. While holding their assets on this infrastructure, all market participants participate in the networks’ passive yield. As the overwhelming majority of the economy enters the global financial system, a tremendous wave of yield generation is now unlocked. As an RIA, you have the opportunity to be the expert on the transition to digital assets and how your clients can benefit. Let’s take a look at how we got to this point and where we go from here.
How we got here
The digital economy’s tech sector has evolved over three main periods. Web 1.0 was the initial iteration of the web into the mid-2000s, allowing companies to host information on static read-only interfaces. Web commerce improved exponentially with Web 2.0. Users interacted with websites directly, creating new, useful data through content creation. In exchange for providing “free” services, Web 2 companies assumed ownership and maintenance of the data. As increasing network effects increased user interactions, data created more valuable insights, increasing the data’s asset value while only costing marginally more resources. Now with Web 3.0, platforms no longer retain ownership of their user’s data. As a platform begins to generate increasing network effects, the dynamic shifts to shared benefit, with the user ultimately owning the data assets.Thus, wealth creation is broadly shared across a community of individuals instead of consolidated by a handful of platforms. This is the origin of the ownership economy.
The traditional financial sector operates on legacy systems where they have a clear data advantage. For instance, global financial settlement can be understood by looking at the SWIFT infrastructure. The SWIFT network was created in 1973 and utilizes a system of trusted member banks. These banks act as nodes along the financial settlement rail, using codes to pass settlement information from bank to bank manually. Due to these legacy processes, international capital settlement can take several days. Domestically, localized systems such as ACH and SEPA facilitate digital financial settlement. While they are marginally better than SWIFT, they share similar problems with manual processes. By ensuring only certain established entities can access the infrastructure, intermediaries maintain the value of their financial data and can charge outsized fees. Problems with legacy infrastructure extend towards centralized entities like brokerages, exchanges, and market makers. Due to the difficulty with moving capital, the centralized entities act as gatekeepers to basic market functions. Businesses and individuals must operate through intermediaries’ manual processes to raise capital or access market functions. Despite the demand and supply for commerce in global markets, unnecessary costs and settlement delays brought about by legacy infrastructure prevent entire business models from existing.
How Digital Assets Produce Passive Yield
Digital assets allow businesses and individuals of any size to tap the financial infrastructure that had previously only been available to the largest companies in the economy. To understand the scale of this opportunity, we can compare two identical digital application companies; one built on Apple’s centralized Web 2 infrastructure and one built on Ethereum’s decentralized Web 3 infrastructure.
The Web 2 application is tied to Apple’s servers, marketplaces, and terms. As the application conducts transactions and earns revenue, they pay an excessive fee to Apple to access their ecosystem, historically around 30% of produced revenue. As the application’s network of user data grows, they can tap this data for business intelligence to create new value. However, the application can only perform analytics on its own raw data set. Since Apple has access to the data sets of the millions of applications on its servers, it can achieve far more profound analysis, making the same data set exponentially more valuable to Apple than to the application producing it. The company can only indirectly incentivize users to create more useful data by using business intelligence to improve services or lower costs. Financially, the company’s potentially global base of customers is siloed. The application must have different processes in place to connect to the specific financial infrastructure of the customer’s country, creating different user experiences. If that company wanted to raise outside capital to grow the business, they could only do so through financial intermediaries like venture capital and private equity to produce private and illiquid security. The costs associated with working with the intermediaries make it economically viable to do so only after reaching sufficient scale, unnecessarily capping the long-term initiatives the application can invest in. Logistical barriers on this infrastructure slow down the growth potential of the application at every turn.
By building on Ethereum’s decentralized Web 3 infrastructure, the same application would find a far more favorable business environment. Instead of the fee for securing their application’s data with Apple, it is decided by the aggregated consensus of the entire Ethereum network. This fee is historically only a small % and tied to the number of transactions, not the value of the transactions themselves. As the company expands its revenue, the long-term cost savings are immense. As the company produces more user data, they can combine it with the data of the rest of the network, allowing their data value to grow. Instead of creating a security through intermediaries to raise outside capital, they could release a digital token using DeFi infrastructure. Various structures exist here, but these tokens have the potential to go far beyond traditional equity. For instance, a token could be the ticket that provides holders with a portion of future revenue produced to token holders. If the market believes the company’s long-term prospects are strong, they are willing to pay a premium to secure this long-term asset. The company instantly gains this premium in its treasury and this could be used to finance long-term investments. Since DeFi is web-native, the application can create a single financial settlement structure instead of a patchwork across different countries. To incentivize users to grow the platform, the company can easily reward early users with incentives tied to the token. Users can hold these assets and capture passive yield or immediately sell it in the secondary market for capital value. In the new digital economy, all stakeholders involved are aligned as they benefit proportionally from the value they create. In this structure, capital easily flows to yield opportunities across the economy instead of being bottlenecked by intermediaries.
Passive Yield
In DeFi, centralized entities that perform basic market functions like exchanges and market makers are replaced by decentralized protocols known as DEXs (decentralized exchanges) and AMMs (Automated Market Makers). In traditional finance, two parties wishing to exchange assets would need to do so through a centralized exchange. The exchange charges a fee to verify the assets’ ownership and logistically transfer the asset’s ownership. To ensure sufficient liquidity for the transaction to clear, they raise capital from select investors and pay them a small percentage reward for providing liquidity. DeFi improves on all of these aspects. Digital assets make it much easier to verify asset ownership as they are transparently available on-chain, allowing the DEX to focus entirely on efficiently connecting buyers and sellers. DEXs let any asset holder provide liquidity instead of allowing only specific capital holders to provide liquidity. A DEX’s software base significantly reduces overhead costs, allowing liquidity providers to retain most of the produced yield for themselves. In DeFi, asset holders can effectively act as infrastructure providers and gain the associated passive yield. Below, we will look at some of the most popular passive yield opportunities available to investors today. This is far from an exhaustive list, and new forms of yield generation are being released as of the time of this writing.
Staking
Staking is the most straightforward type of passive yield generation. Staking is the most popular mechanism Web 3 networks use to authenticate transactions and reward participants. When users create new transactions, they pay a small transaction fee of the native currency of that blockchain. Users can help validate new transactions by “staking” their holdings. When users stake their holdings, they validate transactions in proportion to the amount they have staked compared to the community as a whole. In exchange for helping to validate new transactions, holders are rewarded with a proportional amount of the transactions fees of the network. Staking rewards provide a constant, stable form of yield in the form of the held asset. Even though this stability provides a strong yield floor, it also contains significant capital upside. Since a holder is gaining more of the staked asset, their yield exponentially increases during periods of price increases. Protocol yield represents the passive yield that today’s tech companies earn by maintaining their networks.
Example: Ethereum 2.0
When a user makes a new transaction on the Ethereum network, they pay a small fee in the native currency, Ether. The transaction is validated by a network of other users who have staked their Ether. As a reward for validating transactions, the users who staked their Ether will then receive a proportional amount of the Ether transaction fees collected. As the Ethereum ecosystem expands, there will be an increase in the amount of transactions on the network.
Crypto Loans
By utilizing decentralized lending protocols, digital asset holders can borrow against their assets for liquidity or lend out their assets for yield. In return, the lender receives most of the interest paid by the borrowers as a reward. While this action is similar to margin lending in traditional finance, the digital asset infrastructure gives significant benefits to both parties. When borrowers lock up their long-term assets, they instantly have access to a proportional amount of the asset they want to borrow, providing much greater speed to take advantage of opportunities. Crypto loans are usually highly over collateralized to protect the lender, so the borrower must maintain a very high LTV ratio at all times, often 100%-200%. Smart contracts ensure that payments are made and loans maintain a minimum LTV at all times. When the LTV falls too much, the smart contract automatically liquidates a borrower’s holdings to ensure the lender recovers their capital. Due to greater access to high-yield arbitrage opportunities, borrowers are willing to borrow at high rates. Lenders’ interest rates can reach low single digits to 10%+, much higher than traditional finance. Interest rates are algorithmically recalculated based on active supply and demand across the market. The mechanism provides strong safety to the lenders while providing an opportunity for more upside than purely staking.
Example: Aave
Aave is a decentralized exchange and Automated Market Maker (AMM) It acts as a decentralized connector of borrowers and lenders. The protocol automatically calculates interest rates based on available supply and demand. Borrowers can borrow assets near-instantly to take advantage of opportunities. The low overhead of the automated protocol allows lenders to keep most of the interest payment yield for themselves instead of sharing outsized amounts with the platform.
Liquidity Providing
In traditional markets, market makers maintain a significant amount of capital and provide liquidity for seamless trading in various markets. In exchange for this service, market makers make substantial profits without taking on much risk. It is typically challenging for new market makers to be created in traditional finance due to the need to interact with legacy infrastructure and consolidate significant capital under one entity. In DeFi, AMMs have taken the tasks involved with being a market maker and converted them into open-source software that performs the task automatically through algorithms. By having the logistics of market-making automated, anyone with capital to provide can now take part in this business practice.
Example: Uniswap
Uniswap runs an AMM protocol on a DEX. Users holding an asset can enter the pool as a liquidity provider. When operating as a liquidity provider, users are entitled to a proportional amount of all the trading fees collected by the protocol. Here, traders coming into the DEX can interact with liquidity pools instead of just p2p swaps and makers can provide targeted liquidity to ensure capital in the pools is used efficiently.
Yield Farming
Decentralized protocols often release tokens to share value with the community and encourage greater platform adoption. The token can be released as a revenue-share model and act as a proportional claim to fees generated by the protocol. Tokens can also be released as governance tokens, which provide a right to propose and vote on changes to a protocol. These changes include protocol aspects such as calculating and distributing fees, calculating interest rates, etc. After being rewarded tokens, users can sell them on secondary exchanges. This creates an entirely new yield stream separate from the passive income generated by the protocols themselves. By interacting with various protocols, investors can supercharge their yield while also gaining a more direct say in the communities they are involved in over time.
Example: Compound Protocol
Compound acts as a lending protocol facilitating lending/borrowing activities. Compound rewards both borrowers and lenders with a COMP token whenever they are actively involved with the protocol, on either the borrowing or lending side. This COMP token gives its holder the right to vote on and propose changes to the protocol. The COMP token and its value are tradeable on exchanges. When an investor calculated their final yield, they would include the value of the COMP token alongside the yield generated by the protocol and the asset’s price movement.
Case Study: Anchor Protocol
Entirely new financial products can be created by stacking financial innovations together. The Anchor Protocol, built by Terraform Labs, is an early example. The Anchor Protocol is a wholly new savings product utilizing Terra UST; a digital asset algorithmically pegged 1 to 1 to the US dollar. Anchor provides consistent yields of 10%+ on USD equivalent assets. The protocol acts as a marketplace where users can lend Terra stablecoins (UST) and borrowers can deposit stakeable assets, such as Terra LUNA, to instantly generate a proportional amount of stablecoins. The borrower is essentially giving up their staking rewards for a short time when they deposit their collateral for UST. On the other side of the marketplace, lenders deposit UST and earn yield over time. For example, someone who needed stablecoins for working capital can bond ETH into the protocol and receive a proportional amount of UST that needs to be paid back over time.
The bulk of the yield paid out to lenders is not generated from borrowers’ interest payments in the Anchor protocol. Instead, it is coming from the passive yield generated by the assets deposited by the borrower. When the borrower deposits their stakeable asset, Anchor’s back-end process bonds the assets to the protocol. The bonding process collateralizes the deposits to the protocol while also staking them to earn protocol yield. These staked rewards back up the yield paid out to stablecoin lenders. As discussed above, this protocol yield can have tremendous upside potential during periods of asset increases. During periods of increasing asset prices for staked assets, the yield for the borrowed assets far outweighs the stablecoin yield paid back to depositors. The excess value generated in this period is saved in Anchor protocol’s internal treasury. During periods of declining asset prices, the protocol taps this excess reserve to ensure that depositors still receive their outsized UST rewards. This reserve system keeps long-term interest rates steady regardless of crypto-asset prices.
Conclusion
As we have learned, the entire economy is undergoing a significant evolution from Web2 to Web3. Decentralized finance is the new rail that digital asset ownership will ride, eventually replacing legacy financial systems. Those SMEs and individuals who had fewer data advantages in Web2 will finally have a way to prosper in the global digital world of Web3, a true ownership economy. As these stakeholders onboard their assets to Web3, they are all effectively converted into investors needing to find places to put their assets to work. This tidal wave of investors will need guides to help them allocate their capital correctly. With DeFi changing at the speed of innovation, savvy RIA’s can use an all-in-one provider like Onramp to speed access to digital assets and yield opportunities. For RIA’s that don’t want to miss out on this generational wealth opportunity, join the Onramp platform and become the experts your clients so desperately need.
Sources:
- Bloomberg.com. 2022. Bloomberg – Are you a robot?. [online] Available at: <https://www.bloomberg.com/news/newsletters/2021-05-03/apple-s-30-fee-an-industry-standard-is-showing-cracks> [Accessed 25 January 2022].